Opinion: Investors’ exuberance is at a frighteningly high level

CHAPEL HILL, N.C. (MarketWatch) — The odds of a big decline in the stock market are unfortunately quite high.

Consider the average recommended equity exposure among a subset of short-term market timers tracked by the Hulbert Financial Digest (as represented by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). That average stands at 72.9%, one of the highest levels ever seen. Coincidentally, the Nasdaq Composite on Thursday closed at a record high, and the S&P 500 Index was right behind it.

That’s worrisome from a contrarian point of view. It means that most cash waiting to be invested during opportune moments already has been used up, reducing the fuel that could propel the market higher.

To put the current HSNSI reading into context, consider that its average level since March 9, 2009, when the bull market began, has been 39.4%, only slightly more than half the current reading. In fact, over the past decade, there have been only two occasions when the HSNSI was higher than it is today, and on both occasions the market proceeded to fall:

End of 2013/beginning of 2014: The Dow Industrials fell more than 1,000 points in a month’s time, or 7.3%.

February 2015: The Dow Industrials fell 600 points, or 3.2%.

To be sure, those are only two data points. But they are consistent with the pattern that has emerged over the past 15 years. As you can see from the accompanying table, the Dow on average has done better following readings of 0% and under when it’s been as high as it is currently.

Dow’s average gain over subsequent two weeks

Dow’s average gain over subsequent month

Whenever HSNSI is 70% or higher

-0.9%

-1.5%

Whenever HSNSI is 0% or lower

+0.4%

+1.0%

Notice from the chart at the top of this column that it’s been many months since the HSNSI was as low as 0%. It got down to zero in October, six months ago, and it’s been over two years — November 2012, in fact — since the sentiment index turned negative.

While my statistical work suggests we should worry about the market’s prospects whenever the HSNSI gets as high as it is now, there is an additional reason to be concerned now: We’re fast approaching the end of the seasonally favorable six-month period. May 1 commences the six-month “summer" period in which the stock market’s average historical return has been close to zero.

In other words, the sentiment foundation would need to be particularly strong in order for the market to resist seasonal headwinds. Unfortunately, that foundation today is, instead, unusually weak.

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